Friday, June 26, 2009

Too Big To Fail, Politically

by Simon Johnson

The Baseline Scenario (June 18 2009)

What happened to the global economy and what we can do about it

What is the essence of the problem with our financial system - what brought us into deep crisis, what scared us most in September/October of last year, and what was the toughest problem in the early days of the Obama administration?

The issue was definitely not that banks and nonbanks could fail in general. We're good at handling some kinds of financial failure. The problem was: a relatively small number of troubled banks were so large that their failure could imperil both our financial system and the world economy. And - at least in the view of Treasury - these banks were so large that they couldn't be taken over in a normal FDIC-type receivership. (The notion that the government lacked legal authority to act is smokescreen; please tell me which statute authorized the removal of Rick Waggoner from GM.)

But instead of defining this core problem, explaining its origins, emphasizing the dangers, and addressing it directly, what do we get in yesterday's 101 pages of regulatory reform proposals?

1. A passive voice throughout the explanation of what happened (for example, this preamble). No one did anything wrong and banks, in particular, are absolved from all responsibility for what has transpired.

2. A Financial Services Oversight Council, which sounds like a recipe for interagency feuding, with the Treasury as the referee and - most important - provider of the staff. The bureaucratic principle is: if you hold the pen, you have the power.

3. Some of the largest banks ("Tier 1 Financial Holding Companies", or Tier 1 FHCs) will now be subject to supervision by the Federal Reserve Board - although under the confusing jurisdiction also of the Financial Services Oversight Council in many regards (for example, in the key setting of material prudential standards) and subsidiaries can have other regulators.

4. Tier 1 FHC should have higher prudential standards (capital, liquidity and risk management), but "given the important role of Tier 1 FHCs in the financial system and the economy, setting their prudential standards too high could constrain long-term financial and economic development". Sounds like a banker drafted that sentence. None of the important details/numbers are specified, although the Fed should use "severe stress scenarios" to assess capital adequacy. Is that the same kind of actually-quite-mild stress scenario they used earlier this year?

5. In terms of risk management, "Tier 1 FHCs must be able to identify aggregate exposures quickly on a firm-wide basis". There is no notion here that risk management at these big banks has failed completely and repeatedly over the past two years. How exactly will FHCs be able to identify such risks and how will the Fed (or anyone else) assess such identification?

6. In case you weren't sufficiently confused by the overlapping regulatory authorities in this plan, we'll also get a National Bank Supervisor (NBS) within Treasury. Regulatory arbitrage is not gone, just relabeled (slightly).

7. There is no greater transparency or public accountability in the regulatory process. We still will not know exactly what regulators decided and on what basis. Such secrecy, at this stage in our financial history, clearly prevents proper governance of our supervisory system.

8. There appears to be no mention that corporate governance within these large banks failed totally. How on earth can you expect these banks to operate in a responsible manner unless and until you address the reckless manner in which they (a) compensate themselves, (b) destroy shareholder value, (c) treat boards of directors as toothless wonders? The profound silence on this point from the administration - including some of our finest economic, financial, and legal thinkers - is breathtaking.

There's of course more in these proposals, which I review elsewhere and Secretary Geithner's appearances on Capitol Hill today may be informative - although only if his definition of the underlying "too big to fail" issue uses much stronger language than yesterday's written proposals.

But based on what we see so far, there is little reason to be encouraged. The reform process appears to be have been captured at an early stage - by design the lobbyists were let into the executive branch's working, so we don't even get to have a transparent debate or to hear specious arguments about why we really need big banks.

Writing in the New York Times today, Joe Nocera sums up, "If Mr. Obama hopes to create a regulatory environment that stands for another six decades, he is going to have to do what Roosevelt did once upon a time. He is going to have make some bankers mad."

Good point - but Nocera is thinking about the wrong Roosevelt (FDR). In order to get to the point where you can reform like FDR, you first have to break the political power of the big banks, and that requires substantially reducing their economic power - the moment calls more for Teddy Roosevelt-type trustbusting, and it appears that is exactly what we will not get.